FMI Quarterly - Barnes Dennig

Transcription

Quarterly
issue four
2015
Quarterly
issue four
2015
Publisher and
Senior Editor
Jerry Jackson
Project Manager
Philip Warner
Group Manager
David Harrell
Graphic Designer
Mary Humphrey
Information Graphics
Debby Dunn
Board of Directors
Departmental Editors
Hank Harris
President and
Chief Executive Officer
Strategy
Rick Tison
Mergers and Acquisitions
Chris Daum
Market Research
Randy Giggard
Valuation
Curt Young
Business Development
Cynthia Paul
Ownership Transfer
Landon Funsten
Operations/Project Execution
Ethan Cowles
Private Equity
Alex Miller
Risk Management
Terry Gray
Leader and Organizational
Development
Tom Alafat
Stuart Phoenix
Chairman
Jason Baumgarten
Chris Daum
Landon Funsten
Scott Kimpland
Kel Landis
Charles Thornton
Scott Winstead
Cover Photographer
Bryan Regan
Compensation
Sal DiFonzo
Peer Groups
Kevin Kilgore
Talent Development/Training
Ken Wilson
Succession Planning
Jake Appelman
contact us at:
www.fminet.com
[email protected]
Copyright © 2015 FMI Corporation. All rights reserved. Published since 2003 by FMI Corporation, 5171 Glenwood Ave., Raleigh, North Carolina 27612.
Printed in the United States of America.
DEAR READER
Convergence 4
JERRY JACKSON
QUARTERLY FEATURE
Public Company Underperformance — How Long Will It Last? 8
CURT YOUNG AND CAMERON LARRABEE
SHORTS
Will the Federal Reserve’s Actions Affect the E&C Industry? 22
LEE SMITHER, JOEL STINSON AND PAUL TROMBITAS
The Capitalization of Earnings Method for Construction Firms 30
JOE KAESSNER
Building the Talent Pipeline for Long-term Success 35
KEN WILSON
Five Reasons Why Millennials Are Great for the Construction Industry 41
SABINE HOOVER
Navigating the Winds of Social Economic Changes 45
PAUL GIOVANNONI, PRENTISS DOUGLASS AND CYNTHIA PAUL
Pricing for Profit 51
TYLER PARE AND KEN ROPER
ZURICH FEATURE
Understanding the Fundamental Risks of Mergers and Acquisitions
KAREN KENIFF
64
Convergence
2015 issue 4 fmi quarterly
l 5
Dear Reader,
I
n a long-ago English literature class, one assignment dealt with W.B. Yeats’
The Second Coming, an excerpt from which read:
Turning and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world…
The mental image that came to mind was a centrifuge, hurling its
contents toward some infinite and disparate destinations. This issue of the
“FMI Quarterly” takes the opposite tack as its theme: convergence. Rather
than focus on the bleakness of Yeats’ imagery, we turn our attention to exciting
and challenging possibilities of potentially disparate elements converging to
yield some newer, more advantageous outcome. For example, managing risk
often results in deals being ditched in order to avoid risk altogether. Of course,
in total risk avoidance, few, if any, deals would ever get done. In “Understanding
the Fundamental Risks of Mergers and Acquisitions,” our publishing partner,
Zurich, provides us with a piece on the convergence of risk management
and risk assumption to achieve growth or strategic market entry through
acquisitions after proper deal risk evaluation.
Young and Larrabee in their article “Public Company Underperformance
— How Long Will It Last,” deftly analyze publicly traded engineering and
construction companies to explain why the resurging construction market
has not yet resulted in substantially increased earnings nor large shareholder
payoffs. Several factors converge to yield these results to date, yet the U.S.
construction market continues to be highly attractive on the global front.
“Navigating the Winds of Social Economic Changes” by Giovannoni,
Douglas and Paul blends a metaphor of sailing versus powerboating to fashion
a case for using economic dashboards to steer corporate ships. Further, the
recommended economic metrics don’t just stop at traditional ones (such as
interest rates). Giovannoni, Douglas and Paul call for using metrics from social
economics to better chart market segments to pursue as well as navigate
shifts in the social resources from which future workers will be drawn. Birth
rates, behavioral patterns and construction resurgence converge in Sabine
Hoover’s piece, “Five Reasons Why Millennials Are Great for the Construction
6 l
dear reader
Industry.” Competition for talent will become keener, and Hoover suggests
a focused recruitment strategy as one way to win. In his article “Building the
Talent Pipeline for Long-term Success,” Ken Wilson presents a case study of
a client who contemplated the convergence of a declining worker pool along
with an increasing need for skilled workers and leaders. That foresight led
the company to craft a recruiting and service delivery strategy built upon
talent development.
Rounding out this issue are two articles by veteran FMI stalwarts,
Lee Smither and Ken Roper, each of whom was ably assisted by other key
FMI consultants. Smither, along with Joel Stinson and Paul Trombitas,
takes on the Nostradamian task of predicting how Fed action will impact the
engineering and construction industry of the future in their article “Will
the Federal Reserve’s Actions Affect the E&C industry?” Joined by Tyler Pare,
Roper champions a technique of overhead allocation to projects for estimating
complete project costs prior to assignment of profit. FMI developed this
technique in the early 1960s, even before this publisher began his career with
the firm. The premise still holds today for the self-performing contractor,
according to Roper’s and Pare’s article “Pricing for Profits.”
Even if you don’t read these articles as products of convergence, we
hope that they will prod you into examining both strategy and tactics in your
own firm, as well as considering what new forces may be fast converging with
traditional forces, prompting a need for organizational change. Whether small
or large, if FMI can serve you in both the how, what and when of change,
we would like to talk with you.
Sincerely,
Jerry Jackson
Publisher
Incorporating the
subcontractor
With the U.S. economy in
prequalification
program
recovery
mode,
into project life cycles and the corporate cul-
ture is critical to the successful management of
subcontractors.
one may expect
industry stock prices
to be surging.
However, that has
not been the case.
QUARTERLY FEATURE
CURT YOUNG AND CAMERON LARRABEE
Public Company Underperformance
— How Long Will It Last?
T
he Engineering and Construction (E&C) industry
is certainly no stranger to volatility. It is normal for
the industry to outperform the market during
periods of expansion and underperform the market during periods of
contraction. The exhibits in this article demonstrate this phenomenon
among publicly traded firms participating in the industry pre- and
post-recession. Specifically, the publicly traded companies tracked
by FMI, comprised of 37 general/specialty contracting firms,
significantly outperformed the market in the years leading up to the
Great Recession (see Exhibit 1), but woefully underperformed the
market during the throes of the Great Recession (see Exhibit 2).
With the U.S. economy in recovery mode, one may expect industry stock
prices to be surging. However, that has not been the case. As shown in the
graph below, the stock markets have experienced tremendous gains since the
end of the recession, but contractors have failed to gain any significant traction
in the market. Between June 30, 2010, and June 30, 2015, the S&P 500
outpaced the growth of FMI’s contractor index by 6% (see Exhibit 3). Over
10 l
public company underperformance — how long will it last?
EXHIBIT
1
S&P500 vs. CONTRACTOR INDEX
PRE-RECESSION
JUNE 30, 2005–JUNE 29, 2007
S&P500 Index
FMI Contractor Index*
150
130
110
(PERCENT)
90
70
50
30
10
-10
-30
04/30/07
02/28/07
012/31/06
010/31/06
08/31/06
06/30/06
04/30/06
02/28/06
12/31/05
10/31/05
08/31/05
06/30/05
-50
* Comprised of 37 publicly traded firms (weighted by market capitalization)
Source: Capital IQ
that time, the S&P 500 grew by over 100%, whereas, the median share price
of the firms in FMI’s contractor index climbed less than 40%. As indicated,
the gap in performance has widened over the past couple of years. Specifically,
in 2014 stock markets realized significant gains as the Dow Jones Industrial
Average increased by 7.5% and the S&P 500 posted a gain of 11.4%. Growth
of the S&P 500 cooled in the first half of 2015, with the index expanding by a
meager 0.2% through June 30, 2015. In comparison, the median share price
of publicly traded contractors dropped by 8.1% in 2014, then tumbled an
additional 17.9% during the first half of 2015.
So what is different this time around?
While there is no way to pinpoint the root cause(s) (i.e., the stock market
is a fickle beast after all), a number of forces seem to be in play: 1) Inability to
increase margins, 2) Weak foreign markets, 3) Anemic public funding levels
and 4) A steep decline in oil prices.
Depressed Margins
As indicated in Exhibit 4, publicly traded construction contractors were
able to increase their margins substantially leading up to the recession, with
median EBIT and EBITDA margins peaking at 6.6% and 8.8%, respectively.
Given the lag time associated with construction projects, earnings performance
peaked during the height of the recession, but deteriorated quickly thereafter.
EXHIBIT
2
l 11
RECESSION
JUNE 30, 2008–JUNE 30, 2009
S&P500 Index
10
0
-10
-20
-30
-40
-50
06/30/09
05/31/09
04/30/09
03/31/09
02/28/09
01/31/09
12/31/08
11/30/08
10/31/08
09/30/08
08/31/08
06/30/08
-70
07/31/08
-60
Source: Capital IQ
The severe downturn in market conditions, marked by a heightened
competitive environment, resulted in a multiyear decline in contractor
performance. Considering that markets have started to improve and grow out
of the recession, one would think that margins would currently be displaying
a strong upward trajectory. Unfortunately, as indicated below, that has not
been the case. Margins have remained at reduced levels, effectively bouncing
off the bottom for the past three years. Specifically, since June 30, 2012, EBIT
margins have moved within a range of roughly 3 percent to 4% (i.e., significantly
lower than pre-recession levels).
There are a number of
theories as to why margins have
failed to recover. One possibility is
Margins have remained
that it is just a natural part of the
construction cycle. Pre-recession,
at reduced levels,
the U.S. construction market was
effectively bouncing
firing on all cylinders, fueled by low
interest rates, unsustainable lending
off the bottom for the
practices and investor speculation.
past three years.
Between 2002 and 2006, the U.S.
construction market grew by 35%,
(i.e., an average annual growth rate
12 l
EXHIBIT
3
POST RECESSION
JUNE 30, 2010–JUNE 30, 2015
S&P500 Index
150
130
110
(PERCENT)
90
70
50
30
10
-10
06/30/15
02/28/15
10/31/14
06/30/14
02/28/14
10/31/13
06/30/13
02/28/13
10/31/12
06/30/12
02/29/12
10/31/11
06/30/11
02/28/11
06/30/10
-50
10/31/10
-30
Source: Capital IQ
of 8.3%), far exceeding its long-term growth rate of 3.4%. Notably, certain
segments of the market — housing, for example — experienced much more
rampant growth during this period. With the industry on an upswing and
opportunity abundant, contractors made substantial investments in people,
equipment and systems in order to meet demand. As a result of such investments,
there was a large gap created between supply and demand when the market
turned. Instead of acting brashly and dramatically trimming overhead, many
contractors kept their overhead structures largely intact. With cost structures
failing to adjust to market conditions, margins dropped substantially. Even
with the construction industry a few years into a new growth cycle, capacity
continues to outweigh demand in many market segments and geographic
areas. To restore balance, continued growth will be necessary.
Another theory suggests a more permanent shift in the construction
industry. Over the last several years, the industry has become increasingly
sophisticated. Technology and general advancements have enabled owners
to become more knowledgeable about the construction process and, thereby
pierce profit pockets and squeeze profit margins. Labor challenges, precipitated
by both the downturn in the market and an aging workforce, have further
pressured margins, with employers being forced to increase their payroll per
capita. If such trends continue, and with evidence suggesting that they will,
the margins that we think are low today may just be the new norm.
EXHIBIT
4
10.0
l 13
PUBLICLY TRADED CONSTRUCTION CONTRACTORS
MEDIAN EARNINGS MARGINS
JUNE 30, 2005–JUNE 30, 2015
EBITDA Margin
EBIT Margin
9.0
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
06/30/05
10/31/05
02/28/06
06/30/06
10/31/06
02/28/07
06/30/07
10/31/07
02/29/08
06/30/08
10/31/08
02/28/09
06/30/09
10/31/09
02/28/10
06/30/10
10/31/10
02/28/11
06/30/11
10/31/11
02/29/12
06/30/12
10/31/12
02/28/13
06/30/13
10/31/13
02/28/14
06/30/14
10/31/14
02/28/15
06/30/15
0
Source: Capital IQ
Valuation Multiples Trend Upward
Despite the downturn in performance levels, valuation multiples have
been trending upward. Exhibit 5 displays median valuation multiples, on a
monthly basis, for publicly traded construction contractors between June 30,
2005, and June 30, 2015. The multiples displayed are total enterprise value
(TEV) to operating cash flow (EBITDA), TEV to operating earnings (EBIT),
price to historical book value (P/BV) and price to earnings (P/E). As shown,
valuation multiples, excluding P/BV, plummeted in the latter half of the
2000s, ultimately bottoming in late 2008/early 2009. Since then, multiples
have been on the rise, suggesting that investors believe that stronger earnings
performance is likely in the relative near term. However, over the last couple
of years, publicly traded contractors have failed to deliver on such expectations,
repeatedly missing earnings estimates. In 2014, for example, Aecon Group,
Inc. missed earnings per share (EPS) estimates each quarter, the largest,
occurring in the quarter ending June 2014, was $0.38 below estimates, or
a 319.78% surprise. A number of other contractors have missed earnings
estimates in recent periods as well. For example, Tutor Perini’s EPS during
the fourth quarter of 2014 was $0.56, registering $0.15 below estimates.
Further, Primoris Services’ EPS during the same period came in at $0.17,
thereby missing estimates by $0.32.1
Many of the publicly traded contractors included in FMI’s contractor
14 l
EXHIBIT
5
PUBLICLY TRADED CONSTRUCTION CONTRACTORS
MEDIAN VALUATION MULTIPLES
JUNE 30, 2005–JUNE 30, 2015
TEV/EBITDA
TEV/EBIT
P/BV
P/E
30
25
(PERCENT)
20
15
10
5
06/30/05
10/31/05
02/28/06
06/30/06
10/31/06
02/28/07
06/30/07
10/31/07
02/29/08
06/30/08
10/31/08
02/28/09
06/30/09
10/31/09
02/28/10
06/30/10
10/31/10
02/28/11
06/30/11
10/31/11
02/29/12
06/30/12
10/31/12
02/28/13
06/30/13
10/31/13
02/28/14
06/30/14
10/31/14
02/28/15
06/30/15
0
Median Valuation Multiples
(as of June 30, 2015)
TEV/EBITDA
TEV/EBIT
P/BV
P/E
Median Valuation Multiples
(June 30, 2005-June 30,2015)
8.3
12.2
1.4
18.3
TEV/EBITDA
TEV/EBIT
P/BV
P/E
Range
3.8 - 11.8
5.2 - 15.2
1.1 - 2.9
7.7 - 26.7
Median
8.2
10.8
1.6
17.4
Source: Capital IQ
Enterprise Value/EBITDA > 20.0 not used in median or average; no median or average computed if more than 25% of the companies have multiple outside the limit
Enterprise Value/EBIT > 20.0 not used in median or average; no median or average computed if more than 25% of the companies have multiple outside the limit
Price/Book Value > 5.0 or < 0.5 not used in median or average; no median or average computed if more than 25% of the companies have multiple outside the limit
Price/Earnings >40.0 not used in median or average; no median or average computed if more than 25% of the companies have multiple outside the limit
index are foreign-owned and have significant exposure to international
markets. Thirty or 40 years ago, little construction in the U.S. was performed
by foreign-owned firms. Further, relatively few U.S.-based contractors had
operations in foreign markets. Today, circumstances are quite different,
whereby the largest contractors in the U.S. are performing work on a much
more global scale. In fact, the top-20 general contractors in the U.S. derived
nearly 40% of their revenue from international activity in 2014, based on
information obtained from Engineering News-Record. The U.S. construction
market continues to be highly attractive, given its enormous size and
relatively strong growth prospects and stability. In recent years, a common
theme in the E&C space has been foreign companies penetrating the U.S.
market through mergers and acquisitions.
l 15
Here are a few notable transactions:
WSP Global Inc. acquired Parsons Brinckerhoff Group Inc. from
Balfour Beatty plc for approximately $1.4 billion in cash on September 3,
2014. Parsons Brinckerhoff is a global consulting firm for various
infrastructure projects for both public and private clients. In 2013 Parsons
Brinckerhoff generated just under £1.6 billion in revenue.
Obayashi USA, LLC acquired Kraemer North America, LLC on November
12, 2014. Obayashi USA, a member of Obayashi Group, headquartered in
Tokyo, Japan, agreed to terms to acquire a controlling ownership interest in
Kraemer North America. Headquartered in Plain, Wisconsin, Kraemer North
America provides heavy civil and industrial construction services.
Andrade Gutierrez of America, Inc. acquired The Dennis Group, Inc. on
July 2, 2015. Andrade Gutierrez, headquartered in Brazil, agreed to terms to
acquire a controlling interest in The
Dennis Group. The Dennis Group
offers a wide array of engineering
and construction services to food
While the U.S.
and beverage industries throughout
North and Central America as well
has recovered
as Europe.
meaningfully in the
The U.S. vs. Other Countries
wake of the Great
While the U.S. has recovered
meaningfully in the wake of the
Recession, foreign
Great Recession, foreign economies
economies have been
have been much less fortunate.
Exhibit 6 contrasts the performance
much less fortunate.
of the S&P 500 versus the FTSE 100.
Comprising the 100 most highly
capitalized companies listed on the
London Stock Exchange, the FTSE
100 is generally considered to be reflective of the financial health of the
European Union. Historically, it has trended in conjunction with the S&P
500, indicating relatively high levels of correlation between the economies of
Europe and the U.S. However, that trend has not followed suit over the last
few years, as the European economy has lagged that of the U.S. For example,
Germany, which is widely considered the driving country in the Eurozone,
had annual GDP growth of 0.4%, 0.1% and 1.6% in 2012, 2013 and 2014,
respectively. By comparison, the United States experienced GDP growth of
2.3%, 2.2% and 2.4% over the same period. The lagging European economy
can be attributed to a number of factors. Many point out geopolitical pressure,
specifically the Ukraine conflict, as well as the European debt crisis as the
main drivers behind the sluggish economy.
16 l
EXHIBIT
6
S&P500 vs. FTSE100
JUNE 30, 2010–JUNE 30, 2015
S&P500 Index Value
FTSE100 Index Value
150
130
110
(PERCENT)
90
70
50
30
10
-10
-30
06/30/15
03/31/15
12/31/14
09/30/14
06/30/14
03/31/14
12/31/13
09/30/13
06/30/13
03/31/13
12/31/12
09/30/12
06/30/12
03/31/12
12/31/11
09/30/11
06/30/11
03/31/11
12/31/10
09/30/10
06/30/10
-50
Source: Capital IQ
Regardless of the reasons behind the delayed recovery, both foreign
companies and U.S. companies with material international exposure, are
being adversely affected. Nearly half of the firms in FMI’s contractor-index
are headquartered abroad or have significant operations outside of the U.S.
Such exposure significantly influences the performance of the publicly traded
contractor group as a whole.
While the U.S. has emerged from the recession in better shape than most
countries, conditions remain far from ideal. Activity in certain segments is
substantially constrained by anemic public funding levels. Federal construction
put in place has fallen for each of the last three years, dropping from $31.7
billion in 2011 to $22.7 billion in 2014. This reduction generally stems from
budget issues, increased deficits and surging debt levels. For example, between
2008 and 2014, the U.S. has run deficits ranging from $458.6 billion to $1.4
trillion. Although, the annual deficit has been on a downward trend, dropping
from $1.4 trillion in 2009 to $484.6 billion in 2014. Nevertheless, running such
deficits, which have driven national debt over $18 trillion, has had an impact
on the country’s appetite for continued spending. State and local agencies
have also suffered from funding concerns. As an example, California’s budget
has been stressed in recent years, with one outcome being the underfunding
of its highway/road system, among other issues. In fact, in its five-year
budget that was prepared in 2014, California estimates that the total deferred
maintenance for roads is $59 billion.
l 17
The Oil Factor
A more recent phenomenon attributing to the underperformance of
contracting companies is the steep decline in oil prices. According to Nicole
Friedman of the Wall Street Journal, “Brent crude oil and gasoline futures
both posted 48% losses in 2014.”2 Oil prices are not expected to bounce
back any time soon, given the current coupling of strong supply level with
lackluster demand.
Prior to the downfall, publicly traded E&C firms had become much more
immersed in the oil and gas sector, given the level of opportunity, marked by
countless projects relating to the extraction, transportation and refinement
of oil. Several publicly traded firms had made it an initiative, both through
organic and inorganic efforts, to increase their exposure to serve the oil and
gas market. Some of the larger transactions that have occurred recently follow.
Amec Plc acquired Foster Wheeler AG for approximately $3.1 billion in
cash and stock on January 13, 2014. Foster Wheeler is a worldwide engineering
and construction company
specializing in oil and energy.
For the year ended December 31,
2013, Foster Wheeler had revenues
While the U.S. has
of approximately $3.3 billion.
SNC-Lavalin Group Inc.
emerged from the
acquired Kentz Corporation Ltd.
recession in better
for roughly £1.1 billion in cash on
June 23, 2014. Kentz Corporation
shape than most
provides engineering and
countries, conditions
construction services to oil and
gas, petrochemical, and mining
remain far from ideal.
and metals companies. Kentz
Activity in certain
Corporation had revenue of $1.7
billion for the year ended December
segments is substantially
31, 2013.
constrained by anemic
URS Corporation acquired
Flint Energy Services Limited on
public funding levels.
May 16, 2012, for C$1.25 billion in
cash and the absorption of C$225
million of Flint’s debt. Through
roughly 80 locations in North
America, Flint provides construction services to several companies in the oil and
gas sector. At the time of the transaction, Flint generated roughly 80% of its
revenue in Canada, with the remaining 20% attributable to the United States.
As result of such activity, the performance of publicly traded contractors
has become more intertwined with the movement of the oil and gas sector.
The steep drop in the price of oil has led to a curtailing of capital expenditures
18 l
and a postponement/cancellation of projects. For example, according to
Carolyn King and Chester Dawson of the Wall Street Journal, “Suncor Energy
Inc. said it would cut its 2015 capital spending program by 1 billion Canadian
dollars,” and Canadian Natural Resources Ltd., said “that it would trim its
2015 spending budget by C$2.4 billion to C$6.2 billion, citing the recent drop
in oil price.”3 With companies worldwide cutting projects, there is a heightened
sense of concern for engineering and construction companies with exposure
to the oil and gas industry.
Summary
Historically, the stock prices of publicly traded E&C firms have trended
with the market, albeit with more amplified movement. This trend stopped
after the Great Recession, as publicly traded contractors continue to
underperform the market during a period of expansion. Key factors behind
this phenomenon are the continued depression of margins, global economic
weakness, inadequate funding levels and the contraction of oil prices. Only
time will tell whether the divergence is temporary or more lasting in nature. Q
Curt Young is a managing director with FMI Capital Advisors, Inc., FMI Corporation’s
registered Investment Banking subsidiary. He can be reached at 303.398.7273 or via email at
[email protected]. Cameron Larabee is a valuation analyst with FMI Capital Advisors, Inc.,
FMI Corporation’s registered Investment Banking Subsidiary. He can be reached at 303.398.7204
or via email at [email protected].
1
Reuters
2
Friedman, Nicole. “U.S. Oil Prices Fall 46% This Year, Steepest Loss Since 2008.” Wall Street Journal. December 31, 2014. Web.
3
King, Carolyn, and Chester Dawson. “Suncor Cuts Capital Spending Due to Low Oil Prices.” Wall Street Journal. January
13, 2015. Web.
l 19
Shorts
Will the Federal Reserve’s Actions
Affect the E&C Industry?
LEE SMITHER, JOEL STINSON AND PAUL TROMBITAS
An in-depth look at
how the Federal
Reserve could impact
the engineering and
construction industry.
T
he engineering and construction industry has always kept a
close eye on interest rate fluctuations and the potential impact of
those movements. Most assume that higher interest rates lead to
reduced levels of investment in capital projects. For the past two
years, business publications have been obsessively monitoring the Federal
Reserve (“The Fed”) — watching every word and hanging on every sentence to
see actions it may eventually take regarding the federal funds rate (a primary
influence on interest rates).
The Fed recently indicated that the first rate hike in almost a decade is
likely to happen this year. And while the economy is steadily recovering, it is
still fragile, and Federal Reserve Board Chair Janet Yellen, indicated that the
Fed would move cautiously. “Economic conditions are currently anticipated
to evolve in a manner that will warrant only gradual increases in the target
federal funds rate.”
Driving monetary policy are the Fed’s goals of 2% inflation and maximum
employment (See Exhibits 1 and 2 for unemployment rates and inflation of
personal consumption expenditures). “The Committee continues to see the
1
l 23
EXHIBIT
UNEMPLOYMENT
RATE
Range of projections
Central tendency of projections
Dotted line
7.0
6.5
6.0
(PERCENT)
5.5
5.0
4.5
4.0
3.5
3.0
2015
2
2016
2017
Longer Range
EXHIBIT
PERSONAL CONSUMPTION
EXPENDITURES INFLATION
Range of projections
Central tendency of projections
Dotted line
3.0
2.5
(PERCENT)
2.0
1.5
1.0
0.5
0
2015
2016
2017
Longer Range
risks to the outlook for economic activity and the labor as nearly balanced.
Inflation is anticipated to remain near its recent low level in the near term, but
the Committee expects inflation to rise gradually toward 2% over the medium
term as the labor market improves further and the transitory effects of earlier
declines in energy and import prices dissipate.”
24 l
will the federal reserve’s actions affect the e&c industry?
The Fed signaled that rates might only go up one-quarter of a percentage
point in 2015. Moving forward, the median projection is 1.625% for 2016
and 2.875% for 2017. Interest rates around the world — both short-term
and long-term — have remained low, and right now the U.S. government
can borrow for 10 years at less than 2%. It’s also interesting to note that low
interest rates are not an aberration, but rather a longer-term trend. In the
1960s, interest rates were relatively low, then rose above 15% in 1981 and
have been in decline ever since. Interest rates follow the rise and fall of
inflation, which makes sense as investors demand higher yields when inflation
is high to offset the decline in
purchasing power of the dollars
with which they expect to be repaid.
While the federal
funds rate is important
to watch, FMI contends
that small, incremental
increases in the federal
funds rate is not cause
for concern. What
matters most for the
economy is the real,
or inflation adjusted,
interest rate.
Impacts on E&C
So what does all of this mean
for the E&C industry?
The overall economy has
benefited from low borrowing costs,
which in turn have led to growth
in construction markets. But what
happens when rates start moving
in the other direction? According
to a recent FMI survey, a majority
of respondents believe that rate
increases will have some impact on
their businesses (see Exhibit 3).
While the federal funds rate is
important to watch, FMI contends
that small, incremental increases
in the federal funds rate are not
cause for concern. What matters
most for the economy is the real,
or inflation adjusted, interest rate.
The real interest rate is the most relevant for capital investment decisions.
The Fed’s ability to impact real rates of return, especially longer-term real
rates, is limited at best. Except for the short term, real interest rates are
determined not by the Fed, but by a wide range of economic factors, including
the components of economic growth. Interest rates are only one part of the
equation; the overall health of the economy is a larger driver of engineering
and construction spending. In fact, it is actually worse if the Fed is not
comfortable raising rates due to a fragile economy. Instead of solely focusing
on the federal funds rate, keep an eye on GDP, inflation, unemployment and
residential construction.
EXHIBIT
3
l 25
RATE INCREASE IMPACT
ON BUSINESS
Do you believe rising borrowing costs will directly impact your company/organization’s performance in the next three years?
Significantly 5
7%
4
24%
3
34%
2
Not at all 1
19%
16%
GDP
GDP is a measure of the total output (goods and services) that a country
produces. A nation’s prosperity is directly linked to the amount of goods and
services that it produces, and construction expenditures are a significant part
of our national output (see Exhibit 4). Traditionally, our national output
has averaged between 7-8% with a peak of almost 9% just before the Great
Recession. Additionally, Exhibit 5
shows the historical relationship
between construction spending
and GDP and further forecasts
A nation’s prosperity is
continued growth through 2019.
Based upon historical performance,
directly linked to the
U.S. construction spending has
amount of goods and
room to grow and could once again
align with or possibly even surpass
services that it produces,
nominal GDP. This obviously
and construction
assumes a healthy return to late
1990s economic activity levels.
expenditures are a
significant part of our
Inflation
The Fed’s policies are another
national output.
primary determinant of inflation
and related expectations over the
longer term. The Federal Open
Market Committee (FOMC) judges
that inflation of 2% (as measured by the annual change in the price index for
personal consumption expenditures, or PCE) is most consistent over the
longer run with the Fed’s mandate for price stability and maximum employment.
Over time, a higher inflation rate would reduce the public’s ability to
make accurate longer-term economic and financial decisions. On the other
26 l
4
EXHIBIT
CONSTRUCTION
AS A PERCENTAGE OF GDP
10
9
8
7
(Percent)
6
5
4
3
2
1
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015*
2016*
2017*
2018*
2019*
0
20,000
AND NOMINAL GDP
1,600
GDP
Construction
1,400
1,200
(GDP in Billions)
15,000
10,000
1,000
800
600
5,000
400
(Construction in Millions)
EXHIBIT
5
CONSTRUCTION PUT IN PLACE
200
0
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015*
2016*
2017*
2018*
2019*
0
hand, a lower inflation rate would be associated with an elevated probability
of falling into deflation, which means prices (and perhaps wages), on
average, are falling — a phenomenon associated with very weak economic
conditions. Having at least a small level of inflation makes it less likely that
the economy will experience harmful deflation if economic conditions weaken.
(federalreserve.gov)
l 27
In other words, some inflation is good for an economy. When prices are
increasing, consumers will “buy now” instead of later, thus increasing demand
for goods and services. Stores sell more goods, and production facilities are busy.
In turn, businesses increase hiring to meet demand, and a positive economic
cycle is created.
Unemployment rate
Since 2010, the national unemployment rate has dropped from 9.8% to
just above 5%, while construction put in place has experienced a 5% compound
annual growth rate (CAGR). Exhibit 6 depicts the strong inverse correlation
between national unemployment and construction put-in-place spending. A
strong job market is crucial to the E&C industry. Unemployed or underemployed
people do not build homes, and that
acts as a drag on homebuilding as a
leading indicator of certain sectors
of nonresidential construction,
While many
such as retail, water and sewer and
streets. Looking forward, indications
construction firms do
of full-time, non-farm job growth
not work on singlecan likely be translated into
increased construction spending.
family residential
Job formation is a leading indicator
projects, housing is
for homebuilding. A healthy
employment picture also increases
a key part of the U.S.
consumer confidence, which causes
economy and has a
increased spending in housing and
durable goods, which drives more
direct impact on many
construction activity.
other industries,
including commercial
construction,
manufacturing, banking
and many more.
Residential Construction
While many construction
firms do not work on single-family
residential projects, housing is a
key part of the U.S. economy and
has a direct impact on many other
industries, including commercial
construction, manufacturing,
banking and many more. Housing
starts are defined as the number of
new residential construction units (single-family and multifamily) that have
begun during a month. Generally, the figures are seasonally adjusted and
statistically smoothed to adjust for weather-related impacts. Housing starts
in the U.S. averaged 1,446,000 from 1959 until 2015, reaching an all-time
EXHIBIT
6
INVERSE CORRELATION:
AND CONSTRUCTION PUT-IN-PLACE SPENDING
1,400
25.0
Construction unemployment
National unemployment
Total construction spend
Nonresidential spend
(Unemployment Rate)
20.0
1,200
1,000
15.0
800
10.0
600
400
5.0
200
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015*
0
(Construction Spend Put in Place)
28 l
EXHIBIT
7
0
CONSTRUCTION PUT IN PLACE
700,000
(MILLIONS OF CURRENT DOLLARS)
600,000
500,000
Recession
Nonresidential Buildings
Residential
Nonbuilding Structures
400,000
300,000
200,000
0
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016*
2018*
100,00
high of 2,494,000 in January of 1972 and a record low of 478,000 in April
of 2009. Typically, in a strong economy, people are more likely to buy new
homes than existing homes and vice versa in a down economy. The data
in Exhibit 7 depicts the residential construction market as a leading indicator
for nonresidential construction. Historically, strong housing starts indicate
demand for infrastructure, retail and office space.
l 29
Conclusion
It is likely that the Fed will begin to raise rates this year. Once the initial
rate increase happens, periodic increases are expected. Aggressive increases
are unlikely, as the Fed has indicated a cautious approach. In the short term,
we expect minimal impact on the E&C industry. For many firms, improvement
in the economy and increases in backlogs due to owners advancing projects
to lock in lower rates will offset any negative impact stemming from modest
rate increases.
In the longer term, inflation and the unemployment rate will continue to
drive monetary policy. Although higher than expected inflation and lower than
expected unemployment are not considered likely, these events would lead to
more aggressive rate increases. While the impact to the E&C industry would
not be felt immediately, a delayed effect on firms’ backlogs could be expected.
The state of the economy — not the Fed — will be the ultimate determinant in
the sustainable level of real returns and, thus, the growth of the E&C industry
as well. Q
Lee Smither is a managing director for FMI Corporation’s consulting practice. He can be
reached at 919.785.9243 or via email at [email protected]. Joel Stinson is a consultant
for FMI Corporation. He can be reached at 919.785.9247 or via email at [email protected].
Paul Trombitas is a research analyst with FMI Corporation. He can be reached at 919.785.9256
The Capitalization of Earnings Method
for Construction Firms
JOE KAESSNER
Leverage the right
metrics to better
support and justify
your company’s value.
C
onstruction firm owners are no different from any other business
owner when it comes to wanting to know their business’s value.
Because there are many reasons why a formal business valuation
might be needed — from contemplating a sale of the business to
establishing a value for gift and estate taxes — understanding of the value of your
business is critical. In this article, we’ll discuss one of the most common methods
for determining value and discuss some of the financial and nonfinancial
factors that have real and measurable impacts on the value of your business.
But first, let’s get a few terms straight. The first term is market value.
Think of market value as analogous to the quoted price of a share of publicly
traded stock. It is a value that represents the price at which two unrelated
parties would be willing to exchange a good. In our analogy, the market
value of a share of publicly traded stock is the last price at which a transaction
involving that stock took place. The second term is enterprise value, or the
market value of a company’s equity and debt less the company’s cash. It is
important to be mindful of these terms as we discuss business valuation
because there is often a difference between enterprise value and the value that
an owner would receive when selling his or her ownership interest.
l 31
It’s All Relative
C.S. Lewis once said, “The architects tell us that nothing is great or small
save by position.” I don’t think Lewis was talking about business valuation or
even about our kind of architects when he said this, but he makes an important
point. What better way to find the value of a thing than to compare and
contrast it with the value of another similar thing? To that end, we have what
is known as the Capitalization of Earnings Method of valuation. The basic
mechanics of the capitalization of
earnings method are very simple:
1) Determine a financial metric,
2) Determine a suitable marketBecause there are
based multiple, 3) Multiply the
metric and multiple together, and
many reasons why a
4) Give yourself a high-five for
formal business
valuing your business in less than
10 seconds. Sounds simple enough,
valuation might be
right? Well, if it really were that
needed—from
simple, I probably wouldn’t need to
write an entire article about it (you
contemplating a sale
can still give yourself a high-five for
of the business to
making it this far though).
The first step in the
establishing a value for
Capitalization of Earnings Method
gift and estate taxes—
is to determine an appropriate
financial metric to use. The most
understanding of the
common metrics are revenue or
value of your business
sales, operating income and a
frightfully named abstraction
is critical.
known as EBITDA which stands
for earnings before interest, taxes,
depreciation and amortization.
More simply, EBITDA is used as a
proxy for your business’s cash flow generation. Just how asset-intensive your
business is generally determines which of these financial metrics is the most
meaningful for valuation purposes. Of course, no business valuation would
be complete without a good, long discussion about what actually constitutes
operating earnings or EBITDA. Believe it or not, there are almost as many
answers to this question as there are people discussing the matter.
Once you have your financial metric, it’s time to determine a suitable
market-based multiple. Depending on the purpose of your business valuation,
there are a few different sources of market data from which to derive a suitable
multiple. The two sources of market data that are widely available are public
company financial data and public transaction data. In either case, the end
32 l
the capitalization of earnings method for construction firms
goal is to isolate a list of public companies or transactions that are similar to
yours from an operational, geographic, business risk and size perspective.
Using publicly available valuation figures and financial metrics (generally
from public filing documents, press releases and public markets data), we can
derive a multiple for each public company or transaction which represents a
ratio of enterprise value (remember what this means?) to financial metric.
From the range of multiples we’ve derived, select an average or median
multiple and then make adjustments based on company-specific operational
or market factors (we’ll discuss a few of these below). Once you’ve selected
the multiple, you can calculate enterprise value using a simple multiplication.
Now, give yourself another high-five! Isn’t valuation fun?
Giveth and Taketh Away
Arguably, the most difficult part of this valuation exercise is the selection,
adjustment — and most importantly — justification of the suitable market
multiple to apply to your company’s financial metric. In many instances,
there is a counterparty (i.e., a potential buyer or seller, the IRS or an attorney)
involved in your company valuation. These counterparties will expect you to
logically justify and support your valuation analysis. From the explanation in
the previous section, the process is speciously simple. However, a great deal
of consideration and thought should be given to each adjustment that you
make regarding the selected market multiple. Generally, adjustments are made
based on a combination of financial and nonfinancial factors in the form of
value adders and detractors. We’ll discuss these from a high level so that you
can consider how your own business factors might impact value.
Even though the Capitalization of Earnings Method only uses a
single financial metric to determine enterprise value, there are financial
considerations present in a business that can be used to justify a higher or
lower market multiple. They are:
Value Adders
• Financial — The two most common financial value adders are
relative profitability and growth. Depending on how your company’s
profitability and growth compare to the average profitability and growth
of other similar companies, upward adjustments to the market multiple
can be applied.
• Nonfinancial — For companies in the construction industry, there are
several factors which can be used to justify an upward adjustment in the
market multiple. Self-perform capabilities, project size capabilities, project
pipeline, backlog, flexibility (ability to travel), special relationships with
suppliers or customers, integration across multiple disciplines (if applicable) and the depth of company management could all support a higher
company valuation.
l 33
Value Detractors
• Financial — Excessive use of financial leverage (i.e., high relative debt
levels), excessive use of operating leverage (i.e., inefficient capital program),
and below-average margin or growth figures can all contribute to a
downward adjustment to the market multiple.
• Nonfinancial — For companies in the construction industry, there are
several factors which can be used to justify a downward adjustment in the
market multiple. These factors include concentration of risk in certain key
segments, customers or geographies, backlog and lack of integration or
capabilities compared to peer companies. A significant value detractor
can also come in the form of a lack of organizational depth. With closely
held private companies, there
can often be a tendency to
fail in developing a successor
management team with the
You might have noticed
knowledge and experience to
grow the business once the
that backlog was listed
founder or longtime owner
decides to retire.
as both a value adder
and a value detractor.
If you were paying attention,
you might have noticed that backlog
Backlog is an interesting
was listed as both a value adder and
factor that can be both
a value detractor (and, no, that was
not an error on my part). Backlog
helpful and harmful.
is an interesting factor that can be
both helpful and harmful. On a
positive side, backlog represents
revenue that your business will likely
earn. On the negative side, the terms of the contract that gave rise to that
backlog are set, and profitability depends on efficient project completion. The
nature of backlog is different for each company, so it’s important to consider
which specific projects are in backlog to determine how they impact value.
I Was Told There Would Be No Math
As an example of the Capitalization of Earnings Method we’ve been
discussing, consider the following. We are engaged to value a privately held
industrial contractor called Best Construction, Inc., which reported 2014
EBITDA of $500. Based on a company search, we identify three public
companies that perform that same mix of work and operate in the same
geographic region as Best. Using public filing data, we derive 2014 EBITDA
multiples for each of those companies as shown below:
For our valuation, we select the average multiple of 5.6x as a starting
34 l
the capitalization of earnings method for construction firms
EXHIBIT 1
Selected Public Companies
EBITDA Multiple
Contractors-R-Us
Pretty Good Builder & Sons Corp.
OK Construction Co.
5.5x
6.3x
4.9x
Average of selected public companies 5.6x
EXHIBIT 2
Adjustments
Best Construction is much smaller than the similar public companies
Best Construction has a history of stronger profitability than the similar public companies
Best Construction has extensive self-perform capabilities and the ability to travel easily
Best Construction earns the majority of its revenue from three large, key clients
-2.0x
1.0x
0.5x
-0.3x
Adjusted Market Multiple 4.8x
EXHIBIT 3
Adjusted Market Multiple
Best Construction’s 2014 EBITDA
4.8x
$500
Indicated Enterprise Value of Best Construction (rounded) $2,400
place. We then consider the financial and operation characteristics of Best
Construction. Based on our assessment of some of the value adders and
detractors, we make the adjustments as shown in Exhibit 2 to arrive at our
market multiple.
Lastly, we multiply our suitable market multiple by Best Construction’s
financial metric to arrive at an estimate of Enterprise Value.
Of course, this is a simplified example, and considerably more analysis can
be performed to support the selected public companies and the adjustments
made to the market multiple.
More Art than Science
At the end of the day, business valuation is more an art than a science.
However, if you have some familiarity with the “science” aspect discussed in
this article, you will be better prepared to support and justify your company’s
maximum value. Q
Joe Kaessner is an associate with FMI Capital Advisors, Inc., FMI Corporation’s
registered Investment Banking subsidiary. He can be reached at 713.936.5018 or via email
at [email protected].
Building the Talent Pipeline
for Long-term Success
KEN WILSON
Examining the
importance of solid
development and
succession planning to
the construction industry.
T
alent development and succession planning are critical to the
future growth of all construction companies. i+iconUSA saw that
need and two years ago began focusing on building upon the
talented workforce already on its teams. FdG Associates, a private
equity firm, is the major investor in i+iconUSA, which is a conglomerate of
heavy civil construction companies. Two of these, Joseph B. Fay Company
and i+iconSOUTHEAST (formerly Waterfront Marine Construction, Inc.),
were previously family-owned businesses. The third subsidiary, i+iconENERGY,
was an organic effort. The greater sophistication associated with equity firm
ownership, along with a decreasing labor pool, caused formalized talent
development to become a more critical issue for the entire i+iconUSA family
of companies.
The efforts were led by Ann Michalski, director of program development
and implementation, who has a 20-year background in providing talent
development for construction-related companies, as well as Les Snyder,
CEO and president of i+iconUSA, a visionary leader and a third-generation
construction professional. Snyder indicated that “Developing talent at all
levels is what ultimately makes i+iconUSA a high-performing company. And
36 l
building the talent pipeline for long-term success
as confirmed by our core values, makes us the preference for both employees
and business partners. i+iconUSA identifies, invests in and nurtures
potential while rewarding entrepreneurship. I truly believe that talent must
be developed to increase employee participation and engagement in the
expanding growth of our company.” Michalski added, “We know that our
talent development initiatives will differentiate us and support our strategic
objective of retaining and attracting top talent.”
Future Growth
In order to accomplish their strategic objectives, Snyder and Michalski
realized they would need to enhance the skills and effectiveness of their
management team at all levels. Specifically, they recognized a gap in employee
development in middle management, where the ranks needed to accomplish
short-term goals as well as plan for succession as senior management
retires over the next several years. “We now have a heavy focus on employee
development,” says Ryan Surrena, senior project manager, “and we recognize
our need to transfer knowledge and experience throughout the organization.”
Knowing that they could not overcome this shortage overnight, Snyder
and Michaelski created a five-year development plan that would steadily
upgrade the skills and capabilities of people across the entire firm. They chose
to begin with their critical middle management group at Fay and then extend
the process throughout the field operations team, eventually engaging project
managers, superintendents, general superintendents and project engineers
across all i+iconUSA companies. They included functional managers as well in
order to create a cohesive culture and enhance performance across the company.
Key Objectives
To address the obvious talent gaps, i+iconUSA committed itself to providing
training to enhance the leadership, management and business skills of its
middle managers. At the heart of its efforts was the creation of a pool of capable
managers who will ultimately lead the business and drive sustainable and
profitable growth across the companies. It also gave these emerging leaders
additional responsibilities that would stretch them beyond their current roles.
Although the participants were all well-established and had demonstrated
their capabilities through their successful careers in managing various projects
and functions, each would be required to take on new responsibilities and
expand his or her skills to include a broader understanding of the complexities
of managing a construction company.
Senior leaders willingly provided support throughout the process
and contributed to the curriculum, launched and participated in training
sessions, and refined their skills as mentors and coaches to the program
participants. All took a real interest in the careers of the participants and
formed natural bonds.
l 37
Several members of the first leadership development program have now
developed the confidence to tackle real-world problems and implemented
changes that have improved overall company performance. “I get a lot of
support and can speak directly with our leadership team to get what we need,”
says Tyson Hicks, project director.
“The LDP (Leadership Development
Program) could not have come at a
better time and has redefined me as
Effective project
a person and a leader.”
management requires
Leading a Global Business
Effective project management
short-term attention to
requires short-term attention
detail and the ability
to detail and the ability to react
quickly when anticipating and
to react quickly when
solving problems in the field. By
anticipating and solving
contrast, leading a business demands
a global view of enterprisewide risk
problems in the field.
and a longer time horizon to plan
for the strategic direction of the
business. Rather than just shifting
labor, equipment and materials
to meet daily or weekly schedule needs, company leaders must analyze
external market factors against midterm and longer-term demand to project
organizational resources across future business cycles. Clint Filges, operations
director, describes how “Global financial understanding — or why we bid
what we bid and how to choose jobs — is the area I need to continue to refine.
Being assigned to a task force to work on business plans is another way that I
can improve my skills.”
The i+iconUSA and Fay leadership teams worked with the Talent
Development Group at FMI Corporation to develop a draft curriculum
designed to build skills in these three major areas:
•Management
•Leadership
• Business acumen
Our joint team a phased developmental structure that included these
components:
• Individual and team assessment and interviews
• Curriculum design
• Customized development
38 l
• Program delivery
• Team project development
• Reinforcement and implementation
• Feedback and improvement
After compiling the feedback for each LDP member, we jointly designed a
curriculum to address a broad range of skills, including:
• Management and leadership
• Financial management and cash flow
• Presentation skills
• Client relations and business development
• Strategic thinking and problem-solving
• Negotiating skills and conflict resolution
• Ethics and integrity
• Feedback and team motivation
• Emotional Intelligence
• Risk management
• FMI Construction ProfitAbility©
The resulting curriculum was then translated into a series of seven,
two-day training modules, scheduled every 60-90 days over a period of about
one year. Each session included basic skills development and was customized
to incorporate Fay’s specific processes and procedures to facilitate the
transition from the classroom to apply these new skills while addressing
practical challenges when they got back on the job.
Mike Trettel, business development director, describes the benefits to his
evolving career: “As we began the LDP process, I had just started in the role of
business development, so learning the new role along with the new skills has
been a great opportunity. Improving both hard-edged and soft skills has helped
me as I work with our executive team. I’m learning to lead without being in
charge by effectively leading resources that don’t report to me directly.”
After the classroom training, the participants were asked to take on a
group assignment to identify real-world opportunities for organizational
process improvements. This self-managed team identified a need to challenge
how projects were managed on a day-to-day basis across the company.
Utilizing their new skills of collaboration and team problem-solving, the
group identified inefficiencies and internal obstacles and thus developed
new processes to manage projects more effectively and efficiently across Fay.
Brian Carr, project director, described his own experience: “I have gained new
opportunities to implement the company business plan and drive our strategy
for more work with private sector clients. The challenge for me personally is
to learn to lead as well as to manage depending on a particular situation.”
l 39
Phase Two: Expanding the Culture
After the initial group of participants had been implementing its new
skills for about a year and building a solid foundation of success in the process,
the company expanded the process and trained a much larger group to extend
the commitment to future growth further into the organization.
We gathered the alumni of phase one and members of senior leadership
together to solicit input for designing a modified curriculum for this next larger
group. This group includes about 40 superintendents, general superintendents,
foremen, project managers, project engineers, safety coordinators and IT and
finance personnel from all i+iconUSA companies. Divided into two groups of
20 each, and using input from the alumni group, the team prioritized course
materials to create a series of six, one-day modules. Each module would be
delivered for the two groups on two
consecutive days every 30-60 days,
with a break during the busy
summer construction months.
This series would also include
There are intangible
FMI’s two-day Construction
benefits to bringing
Profitability business simulation for
each group to facilitate the practical
people together across
application of the skills and make
various companies
the transition from the classroom to
field implementation. This process
and locations.
was also accelerated by the hands-on
participation of the alumni group,
which sat in on the classroom
sessions and offered insights into
how the skills can be applied in the field. Alumni also provided guidance as
each module was developed to make sure that a consistent message was being
communicated to this broad group of program participants.
In addition, feedback is collected through a customized online survey
immediately after the delivery of each training module. This feedback is
analyzed to make changes to future modules to accommodate participants’
needs. The learnings from each module are also reinforced through a series of
tailored one-page reminders that are sent to all participants between sessions
to create a link from the classroom to the real world of field operations.
Outcomes and Benefits
Besides the inherent benefits of training for a broad group of people across
the organization, there are intangible benefits to bringing people together
across various companies and locations. Some of the participants don’t
encounter each other during their normal workflow, so this platform results in
a more cohesive and collaborative culture as well as a vehicle for sharing best
40 l
practices across the various operating divisions. Although they deliver
different kinds of contracted services, there is the common thread of heavy
civil construction. This helps to create a synergy for problem-solving and
leveraging operational excellence.
This facilitated interaction has created a pipeline to support future growth
in both geographic and targeted market sectors. Ryan Surrena describes his
relocation from Maryland to Pittsburgh as the biggest opportunity: “Through
my involvement in the leadership development program, I was able to see past
the actual construction of the projects and start to see the big picture and how
the company is truly evolving. Relocating back to the Pittsburgh area was not
only ideal for my family, but also provided me the opportunity to use the skills
that I learned to lead and manage much larger projects.”
It will take a while for i+iconUSA to reap the long-term benefits of its
investment, but individuals like Hicks are already seeing a difference.
“We have always treated employees well, but over the past few years, the
company has become more attractive and more people desire to join us based
on the perception in the market of how well people are treated and the time
and effort placed on employee development and growth,” he says. This
culture will help i+iconUSA achieve its objectives of becoming a best-of-class
employer of the future. Q
Ken Wilson is a director for FMI Corporation. He can be reached at 919.785.9238 or via email
at [email protected].
Five Reasons Why Millennials Are
Great for the Construction Industry
SABINE HOOVER
Now is the time to
start incorporating
a millennial-focused
recruitment strategy
for the workplace.
2
015 represents a milestone in the U.S. labor market. For the first
time, millennials (individuals born between 1980 and 2000) will
become the majority in the workforce. This is a significant shift for
companies that now have to figure out how to most effectively
attract, recruit and retain these younger workers — not all of whom are
following in their parents’ footsteps when it comes to job selection, company
loyalty and opportunity.
Much has been written about the millennials and how they differ from
previous generations in their approach to work — and careers in general.
Indeed, millennials are often unfairly saddled with the dubious reputation for
being entitled, disloyal, self-centered or optimistic go-getters, but it turns out
that they’re actually not that different from their older work colleagues. In
fact, Chuck Underwood, a pioneering and longtime authority on generations,
pointed out that, “Millennials are idealistic; they are demanding; they will
insist that their employers are good corporate citizens, environmentally green
and ethical. In many ways, they are exactly like the baby boomers and that’s
not an accident. Most have boomers for parents, and they absorbed their
parents’ values.”1
EXHIBIT
42 l
five reasons why millennials are great for the construction industry
1
MILLENNIALS BECOME THE
MAJORITY OF ALL EMPLOYEES IN 2015
GENERATIONS IN THE WORKPLACE: 2015 IS THE YEAR MILLENIALS
BECOME THE MAJORITY IN THE U.S. WORKFORCE
Millennials
Generation X
Baby Boomers
45%
2015
21%
31%
36%
2010
22%
38%
25%
2005
23%
45%
Source: Bureau of Labor Statistics Employment Projections
Underwood’s notion was confirmed in a recent study conducted by the
IBM Institute for Business Value, where the authors stated that the differences
among millennials, Gen X and baby boomer employees have been grossly
exaggerated.2 According to the survey findings, baby boomers, Gen Xers
and millennials share similar values, aspirations, attitudes and goals when
it comes to work. The survey also found that some of the more common
assumptions regarding millennials could actually be incorrect.
FMI has observed similar misconceptions about millennials in the construction industry. In a recent study, FMI surveyed more than 200 millennials
in the industry to measure their level of engagement and to explore what this
generation of workers is looking for in an employer. Following are preliminary
survey statistics3 — some of which dispel widespread millennial stigmas:
• 74% of survey respondents expect to remain more than five years with
their company.
• 96% of survey respondents are willing to work beyond what is required
of them to help the business succeed.
• 93% of survey respondents feel proud to be part of their company.
• 98% of survey respondents stated that it was important for them to
understand their career path and opportunities within their company.
• The following criteria ranked highest for millennials in construction:
1) Competitive pay 2) Work-life balance and 3) Personal development.
l 43
Based on the above excerpt of findings and additional conversations with
industry stakeholders, we have identified the following five key areas that
make millennials a force to be reckoned with in the construction industry:
1. Loyalty and dedication. The majority of our survey participants want
to stay more than five years with their company, as opposed to jumping ship
in the near term. Given good opportunities for career advancement, support
for education, a collaborative culture, and competitive pay and benefits, this
group of workers will go above and beyond to drive organizational success.
2. Innovative thinking. In an industry that is changing dramatically
through emerging technologies and new delivery systems, millennials
welcome the opportunity to provide input and new ideas that promote
corporate innovation. As one survey participant stated, “I’m free to be
creative and try new things.” Progressive companies like DPR Construction,
for example, encourage employees to use a special website to submit ideas
for improvements, which can be related to software, tools or company
protocols, among other things.
3. Tech savvy with a personal touch. It is true that many millennials
adopt new technologies and gravitate toward digital media more easily than
do their older colleagues. However, when it comes to learning new skills at
work, research shows that millennials prioritize face-to-face contact over
digital options. FMI’s survey also
confirmed that 86% of respondents
favored face-to-face feedback rather
than a digital setting. This mix of
When it comes to
tech savvy, combined with a need
for personal interaction, can help
learning new skills at
companies drive change across
work, research shows
multiple generations while infusing
the industry with a fresh new
that millennials prioritize
perspective.
face-to-face contact
over digital options.
4. Balance. Millennials are
looking for a healthy work-life blend.
This can be difficult to attain in the
construction industry, which often
requires long hours, remote work or
challenging work conditions. However, if employers want to recruit and retain
star talent, they will need to reconsider some of their traditional corporate
policies and practices and find new ways to create a healthy work-life blend
for their employees. For example, offering a paid sabbatical can help give
44 l
five reasons why millennials are great for the construction industry
employees a break and a fresh outlook without losing them for good. This will
not only help workers across multiple generations, but will also improve the
negative image that the industry has suffered for decades.
5. Collaboration and communication. According to Underwood, many
millennials grew up with parents, teachers and counselors who were their best
friends and role models. “They not only need a mentor, but also a buddy. They
are excellent team players. They will care about the entire organization, not
just their own jobs,” stated Underwood.4 Indeed, the timing is perfect. New
virtual design and construction tools and integrated project delivery methods
will all require higher levels of collaboration within and among project teams.
Having these young people focused on a common purpose, effective processes,
excellent communication and solid relationships will help transform the
industry over time.
While managers often perceive millennials as entitled, disloyal and lazy,
it appears that they really aren’t. As shown in FMI’s recent construction
industry survey, millennials are ambitious and eager to make a big impact in
their careers early on, which sometimes can be misread as entitlement.
Not unlike other generations that enter the workplace, millennials have
new perspectives to share, new ideas about getting things done and new ways
of tackling problems. They were literally born with technology in their hands
and see it as a critical part of the workplace and their interactions with others.
Long thought to be “behind the curve” when it comes to technology adoption,
the construction industry desperately needs this new perspective.
This new perspective is critical, because it’s what can push all of us forward
(whether we want to be pushed or not). So, rather than focusing on outdated
stereotypes, employers in the construction industry should start building
comprehensive human capital programs that will benefit workers across all
generations. Now is the time to capitalize on each other’s strengths instead of
focusing on stigmas. Q
Sabine Hoover is a senior research consultant with FMI. She can be reached at 303.377.4740
1
“The Millennials: Who They Are, And Why They Are a Force to be Reckoned With.” Judy Schriener. ENR. 02/23/2011.
2
“Myths, exaggerations and uncomfortable truths. The real story behind millennials in the workplace.” IBM Institute for
Business Value. January 2015.
3
Final results and interpretations will be released in fall 2015.
4
“Millennials Bring New Attitudes.” Luke Abaffy. ENR. 02/23/2011.
Navigating the Winds of
Social Economic Changes
PAUL GIOVANNONI, PRENTISS DOUGLASS AND CYNTHIA PAUL
Understand the
changing dynamics of
social economic factors
like income inequality
to be proactive in
shifting markets.
S
ailing versus boating can be likened to how companies view their
markets when planning for their futures. To a sailor, an open body
of water represents freedom. It is open space, a time to apply the
skills learned to achieve the goal. Captains set their destinations,
trim the sails and plot their courses toward those destinations. Their routes
rarely follow straight lines. Currents and wind directions determine their
tacks. While their general direction is strategic, their interim steps are tactical
in response to their environments.
Boaters, on the other hand, are propelled by mechanics and engines
and think about their journeys a bit differently. Where sailors crisscross the
winds to maintain forward momentum, boaters can take a straighter path
from their point of launch to the destination. Sailors and boaters make
adjustments based on current flow, but power boaters have less concern about
current than do sailors. Both can decide to explore the backwaters, eddies and
natural beauty along their routes. Sailors and boaters share many of the same
planning elements that go into a successful day on the water; they simply
have different ways to achieve their goals.
46 l
navigating the winds of social economic changes
Companies chart their courses for the future like skippers. Some will
choose to venture far, while others will stay on the shore or in the harbor.
Some are more interested in the journey, and others are more fascinated by
the destination. Some will be propelled on the mechanics of wind, while
some use fossil fuels, electronics and gears to enable their journey. But both
need to deal effectively with the wind and waters in order to be successful
and safe. The water is the market that companies face in their journey toward
their futures.
Your geographic market or market segment is your waterscape. You can
choose to stay where you are, venture a little ways beyond the harbor, or set
sail for distant shores. Just like sailors and boaters, you have to understand
and interact effectively with the forces of nature to gain a safe passage
across the water. After all, who would intentionally set sail in a small boat
against gale-force winds when going a bit earlier or waiting an hour would
dramatically change the height of the waves? If speed to destination were the
intent, who would choose to sail versus powering up the engines?
Grab Hold of the Helm — Let’s Go
Skippers stand at the helm and guide their craft safely forward much like
companies that use economic dashboards to help them judge the waters ahead
and prepare for changing conditions. Many, if not most, successful industry
firms use economic dashboards as early warning tools to changing markets,
competitive positions and economic fluctuations. Like the label suggests,
economic dashboards are heavily focused on the fiscal economics impacting
markets — e.g., GDP growth, interest rates, employment/unemployment levels,
per capita income, housing starts, etc.
Social economics are driving markets in increasingly obvious ways. They
impact how markets grow and decline, the availability and quality of talent,
and, in many cases, the severity of economic changes that will be felt in times
of expansion and recession.
White Caps and Rogue Waves — Reading the Gauges
Those who track fiscal economic indicators attempt to predict the next
recession or “rogue wave.” However, many tend to ignore the socioeconomic
factors or “white caps” that affect their companies’ competitive positions on a
day-to-day basis. Social economics impacts the way firms stay competitive and
engage human capital.
Consider, for example, the socioeconomic metric of income disparity.
Income disparity is a measure of the gap between the very rich and the very
poor in a geography. A recent article by The Brookings Institution examined
income disparity in 50 of the largest United States cities and found the
disparity in many of the cities, like Atlanta, San Francisco and Miami, had a
significant increase in income inequality from 2007-2012. Though these three
l 47
cities had increasing levels of inequality, it occurred through different means.
In San Francisco, for example, the wealthiest households saw an approximately
$27,800 increase in income, while the poorest households had an approximately
$4,300 decrease in household income. The rich got richer, and the poor became
poorer there. The scenario was different in Miami and Atlanta, where the poor
saw a decrease in household income,
and the rich did as well, but to a
lesser proportionate extent.
Income inequality is a broad
The ability to track
look at the social economic
environment within a specific
individual metrics
geography. To create an actionable
provides the opportunity
plan based upon fluctuation in
this metric, one must look to the
to focus efforts on one
individual variables that show
or more socioeconomic
correlation to the broader metric.
Individual variables such as education
factors that is affecting
attainment, housing-to-income
the broader external
ratio, population density and
commuting time all have statistically
environment.
significant correlations to income
inequality, and, as such, variations in
income inequality can be explained to
varying degrees by these individual
metrics. For example, 32.5% of the variation in income inequality can be
explained by variation in population density. What this suggests is that, as
population density within a geography increases, a negative effect on income
equality would likely result. This correlation coefficient may not seem high
when comparing it to one expected in a laboratory environment; but when the
subject matter involves the unpredictability of human behavior and outcomes,
the correlation is high. When a metric, such as population density is observed
to be increasing, a proactive firm may react by adjusting its compensation plan
to retain existing talent or be more attentive to its pursuit of new talent.
The ability to track individual metrics, such as those listed above, provides
the opportunity to focus efforts on one or more socioeconomic factors that is
affecting the broader external environment. This allows the opportunity to react
quicker and more efficiently to the changing dynamics at hand and ultimately
create competitive advantages over competitors within your geography.
Charting Your Course — Why Does It Matter?
So why should individuals or companies care about rising income
inequality or other socioeconomic metrics, especially if it is an issue that
might primarily be dealt with at agency levels (local, state and federal
48 l
government)? Does it actually have a material impact on firms, and, if so,
how can firms react? Leaders and managers should care and monitor these
metrics within their individual geographies because they provide a strong
measure of how they need to think about their talent pipeline. If you are
located in a market with rising income inequality, you should expect to see
increasing salary expectations coinciding with decreasing availability of
talent. Companies should think harder about cultivating the talent they need
internally rather than expecting to find it in the marketplace at a bargain
price. Company “universities,” internships and apprenticeships through high
schools, technical colleges and co-ops are several examples of how some firms
are succeeding at the talent challenge.
As a socioeconomic metric, income inequality is simply a number that
compares the spread between the highest- and lowest-earning households.
When this ratio gets larger over time, several factors come into play, including
decreased social mobility, high and persistent unemployment, and lower
economic utility (the value of an additional unit of service or good). For
example, with decreased social mobility, it becomes more difficult for someone
to migrate from the lower to the middle class. Fallout from these issues can
take the form of additional health and social challenges such as obesity, crime
rates, substance abuse, unrest, waste of resources and so forth. When these
factors persist over time, geographic regions begin to experience an erosion of
the middle class as consumers struggle to afford essential goods and services.
Over time, income inequality dampens economic growth. This erosion
presents a tremendous struggle for construction firms because most of the
industry’s production and entry-level jobs exist within the middle market. This
is one of several reasons why hiring staff has become so challenging over the
last several years. Find a city in the
U.S. where construction is happening
at a torrid pace, and the talent
supply-demand relationship will
If you are located in
likely be heavily weighted in favor of
the talent. Companies are running
a market with rising
at capacity, have good backlog, enjoy
income inequality,
healthy margins and cannot find
enough people to fill their current
you should expect to
staffing needs. Compounding this
see increasing salary
issue is the fact that many people
left the construction industry as a
expectations coinciding
result of the recession and housing
with decreasing
market bust. If firms are unable to
hire for open positions, then the
availability of talent.
discussion of talent development
must be the next piece of the puzzle.
l 49
Connecting the dots, rising income inequality leads to a diminished
middle class and ultimately a constrained talent pipeline for companies.
Income inequality impacts education, commute times, availability of talent
(and therefore the cost of talent) and so forth. It also has a dramatic impact on
the attractiveness of the area, thus limiting the number of people from outside
of the area who wish to move into
the area and make it their home.
Given the context of a
diminishing talent supply, a market
Income inequality and
that is unattractive to new recruits,
and increasing project complexity,
other socioeconomic
how will your company confront
metrics like GDP growth
the challenge? Just as companies
develop a strategy for market entry,
and unemployment
companies also need to prepare a
levels are the dashboard
talent strategy for their own staff
by assessing the external dynamics,
tools that help leaders
taking stock of internal capacity
understand what
and committing resources toward
objectives. Proactive firms come
opportunities and
up with creative solutions to these
challenges, such as intern and co-op
dangers lie ahead.
programs to cultivate younger staff.
With the higher starting salaries
expected in a geography with
rising income inequality, allocating
resources to develop the staff that is already a good cultural fit within your
company may prove to be a better value compared to the costs associated with
recruiting, interviewing and hiring new talent at competitive market salaries.
Training and development yields the greatest dividend when it is tied to the
company’s overall strategy.
The successful skipper ensures that his boat is seaworthy. He or she has
the appropriate crew for the planned adventure and pursues an appropriate
strategy with tactics that will achieve the destination. Successful leaders fill
similar roles. As the skipper stands at the helm, the instruments provide
signals for tactical shifts. Similarly, income inequality and other socioeconomic
metrics, like GDP growth and unemployment levels, are the dashboard tools
that help leaders understand what opportunities and dangers lie ahead.
Conclusion
The construction industry environment has changed significantly in
many regions over the past five to seven years and should continue to change
nationwide for the foreseeable future. The contractor selection process is
50 l
changing from one based primarily on price — a residue of the recession —
to a process that considers the total value that a contractor brings to the
project. Though this trend is not consistent across the country, many cities
and regions have already made the shift as the war for talent has allowed
contractors to get more selective on the customers and projects they pursue.
This shift towards selection based on value creates an opportunity for
contactors to leverage competitive advantages that are not cost-related.
Competitive advantages in value selection projects stem from experience,
unique systems, depth of process or client knowledge, and capabilities of
staff and project teams. A contractor that is operating in these value-based
procurement environments must act upon the external, socioeconomic metrics
that directly influence its ability to retain and attract top-tiered talent. Q
Cynthia Paul is a managing director with FMI Corporation. She can be reached at 303.398.7206
or via email at [email protected]. Prentiss Douglass is a consultant with FMI Corporation.
He can be reached at 919.785.9240 or via email at [email protected]. Paul Giovannoni
is a research analyst with FMI Corporation. He can be reached at 919.785.9216 or via email at
[email protected].
Pricing for Profit
TYLER PARE AND KEN ROPER
Exploring common
challenges in overhead
allocation/recovery in
the construction industry.
“W
e lost a little bit, but the job still made money.” If you are a
construction business owner, and you have heard similar
words from your employees in the past, you may be reaching
for an antacid right now. As a business owner, you know
that “making money” at the project level does not necessarily equate to a profit
on the project after overhead allocation. Projects must generate marginal
contributions in excess of total selling, general and administrative (overhead)
costs in order for the business to generate an operating profit and produce a
positive return on investment.
Contribution Margin = (Project Revenue - Project Direct Costs) / Project Revenue
*Contribution Margin is also commonly referred to as Operating Gross Margin or, simply, Gross Margin
Creating the Right Pricing Balance
Intuitively, all contractors understand that they have to cover overhead
costs for the business to break even. Operating costs, costs beyond those
charged to the projects, are realities. However, how much overhead cost should
52 l
pricing for profit
you budget for at the project level? Budgeting for too much overhead can
result in noncompetitive pricing. This could prove problematic for a business
model that relies on continuously adding volume to an ever-evaporating backlog of work. Budgeting for too little overhead can result in negative operating
profit — i.e., the marginal contribution from project revenue is less than the
overhead costs of running the business. In this latter scenario, the contractor
is essentially donating its equity to finance the construction project.
The question remains, “what is the right amount of overhead to allocate
to each job?” Most methods of overhead allocation are based upon some
relationship of overhead costs to direct costs. Theoretically, the more direct
costs incurred by the project, the greater overhead resources required, and,
therefore, more overhead costs are
allocable to that specific project.
For this article, the assumption
is that contractors are accurate
Commingling overhead
in their direct cost estimates,
quantitative takeoffs are precise,
and profit expectations
and accurate information on
production rates is readily available.
into a single ratio is
If direct costs are inaccurately
a very crude and
estimated, any application of
overhead based on direct costs will
dangerous approach.
be similarly inaccurate.
Many contractors “mark up”
direct cost to compute the final
contract amount. This markup
ratio accounts for both project overhead and profit expectations. Commingling
overhead and profit expectations into a single ratio is a very crude and
dangerous approach. Because each project incurs overhead at a different rate,
applying a single markup ratio will result in variable profit expectations to
the extent that the true application of overhead varies from job to job. Profit
expectations should be developed with a strategic view of the project opportunity
incorporating customer relationships, competitive landscape, project risks
and expected return on investment. Assume that overhead and profit are
decoupled in your pricing model. At a minimum, projects must contribute
enough margin to cover overhead — i.e., breakeven. Beyond covering overhead
costs, projects must return operating profit to the business in order to:
• Service debt obligations and provide an acceptable equity return
to investors.
• Build retained earnings to finance future growth and protect against
recessionary cycles that occur in the construction industry.
l 53
The subjective portion of operating profit expectation is your anticipated
equity return. Ask yourself, what is an acceptable return on my equity
investment in the business? Due to the risks associated with construction,
FMI argues that contractors should expect 25% to 40% returns on their
investments. Think about the expected returns to alternative investments:
• Five-year average total returns for retail investments
(Morningstar.com, 8/26/2015)
•DJIA
13.12%
• S&P 500 13.13%
•NASDAQ 17.26%
You can calculate your company’s return on equity by dividing net income
by total net worth. Is your business realizing an acceptable return on equity?
If not, you may need to consider raising your prices.
Many contractors assume that accounting for all overhead costs and
acceptable profit on certain jobs will price them out of the market and that
there is a certain price “that the work will go for,” regardless of margin. If the
goal of the business is solely to win work and execute projects, this philosophy
is sound. However, if the business
truly exists to generate profits,
then overhead and profitably must
be stringently considered on every
If the business truly
project opportunity. If you cannot
win work at acceptable margins in
exists to generate
your current market, you may need
profits, then overhead
to consider:
• Shifting strategy and pursuing
other markets
• Increasing customer selectivity
within core markets
• Improving project execution
• Rightsizing the organization
and reducing overhead
and profitably must
be stringently
considered on every
project opportunity.
Another common mistake in the industry is using the terms “markup” and
“margin” synonymously. Markup is the ratio of contribution margin to direct
costs, while margin is the ratio of contribution margin to revenue. Because
overhead costs are viewed as a percentage of revenue on common-size profit
and loss statements, companies should consistently view project contribution
margin as a percentage of project revenue. This means reviewing project pricing
and identifying the overhead as a percentage of contract revenue. At the
54 l
pricing for profit
point of pricing work, the estimated direct costs are known, yet the intended
revenue has yet to be determined. Using the income statement ratios of
margin and applying those to the direct costs of the job being priced will lead
to substantial underpricing of the project. For example, if a contractor has
annual overhead totaling 15% of annual revenue and marks up estimated
direct costs at 15% in order to break even, the contractor is only allocating
13% margin as a percentage of project revenue. This pricing approach is
fundamentally structured to incur an operating loss of 2% before any profit
is added to the overall price.
Overhead recovery is not optional. Overhead represents costs that are
generated by the contracting process. Ideally, every single overhead expense
account is individually allocable to the projects executed during the period.
Contractors must also demonstrate consistency in their costing philosophy
— i.e., which costs are to be charged “above the line” (to the job) and which
costs are to be charged “below
the line” (to overhead). The most
commonly debated cost is project
management salaries. Should project
Overhead recovery is
manager salaries be charged to the
job, or should they be considered
not optional. Overhead
part of overhead? Most importantly,
represents costs that
costs should be accounted for
consistently. If not, contractors run
are generated by the
the risk of budgeting for project
management wages in the direct
contracting process.
costs and then applying an overhead
rate that accounts for project
management wages — essentially
double counting the cost of project
management for the project. This is true for all costs that lend themselves to
ambiguous categorization, including estimating, engineering, purchasing,
hauling and so forth. Wherever possible, FMI recommends charging costs to
the project. This ensures accounting for costs in the sales/bidding process and
recovering those directly through project execution. What is not acceptable is
to attempt to recover those costs through overhead allocation on some jobs
and through direct cost estimates on other jobs. Such lack of discipline will
lead to both confusion and disappointing profit results.
The four critical factors to consider when developing a practical, usable
overhead application method are as follows:
• The method should be based on a relationship among direct cost items.
A direct cost is determined in the estimating process and directly charged
to a project as incurred over the project’s life.
l 55
• The method should accurately match overhead costs that are incurred
over the life of the project. This requires a comprehensive budgeting
process to determine the overhead that will be applied to future projects.
• The method should properly match the risks and overhead costs
associated with managing labor.
• The method should minimize clerical effort and other computational costs.
EXHIBIT
Dual-Overhead Rates
For construction companies that employ direct labor as “self-performing”
contractors, special attention should be focused on the overhead markup and
recovery process. A total direct-cost overhead recovery method or a labor-cost,
markup-only process are both ineffective ways to cost and price jobs. The most
accurate method of overhead recovery is the dual-overhead rate method. With
this method, different markup rates for materials and direct labor are based on
the company’s current operating budget. Labor represents the single largest
component of risk and opportunity for profit on most construction projects.
Labor will also generate the greatest amount of overhead and, accordingly,
should receive the largest allocation of that overhead.
Based on many years of research on the behavior of overhead costs, the
dual-rate method reflects the finding that overhead costs vary as the ratio of
materials and subcontracts to labor varies. This method supports the basic
theory that overhead (as a percent of total direct cost) goes down as ratio of
material and subcontractors to labor goes up. The formulas for determining
the dual-overhead rates are given in Exhibit 1.
The dual-overhead-rate method is so named because two different
markup percentages are applied to recover overhead — one rate on labor and
a separate rate on materials and subcontracts. Labor is a significant driver
of overhead costs. Intuitively, this makes sense when you consider that labor
requires more management time and attention than procurement of materials
and subcontracts. In addition, labor management generates significant
1
FORMULAS
FOR DETERMINING DUAL OVERHEAD
Rate on Materials and Subcontracts
=
Overhead
[(X) Labor] + Materials and Subcontracts
Rate on Labor
=
(X) Overhead
56 l
pricing for profit
additional costs. This dual method applies one percentage markup on materials
and subcontracts costs and a significantly higher markup on labor costs.
The need for such a dual rate results from the fact that different jobs use
different proportions of materials and subcontracts and of labor. Jobs with
low materials and subcontract-to-labor ratios have relatively low materials and
subcontracts costs and, therefore,
relatively high labor costs. A special
condition exists with equipmentintensive contractors like highway
The dual-rate method
and utility contractors. They
can elect to treat equipment costs
of overhead recovery
similarly to labor in these calculations
has proven to be
with the understanding that such
equipment expenses tend to
more accurate than
generate relatively high amounts
of overhead similar to labor.
any other method.
The dual-rate method of
overhead recovery has proven to
be more accurate than any other
method, and many self-performing
contractors across the country have switched to this method of recovering
overhead. This relatively simple method is applicable for all ranges of
materials and subcontract/labor ratios. The method is limiting for large
general contractors that do not self-perform work or contractors that
primarily use the construction manager delivery method, namely because
these contractors and types of contracts lack a significant component of labor
to which overhead can be allocated.
Sample Calculation
Values for X used from Exhibit 1 are determined by the materials and
subcontract-to-labor ratio and are found in the table of overhead factors in
Exhibit 2. Values for overhead, labor, materials and subcontracts are provided
from the company’s budgeted profit and loss statement.
The dual-overhead rates for the hypothetical contractor with the budgeted
income statement in Exhibit 3 are determined as follows:
Materials = $13,590,000
Subcontracts = $620,000
Labor = $4,860,000
Overhead = $5,040,000
M&S/L Ratio = $13,590,000 + $620,000
$4,860,000
= $14,210,000 = 2.92/1
$4,860,000
EXHIBIT
2
l 57
OVERHEAD FACTORS
FOR DETERMINING DUAL OVERHEAD
X = Antiloge [2.1 – 1.5 (.8 M&S/L)]
M&S/L = Materials and Subcontractors/Labor Ratio
(1)
M&S/L
(2)
X
(3)
M&S/L
(4)
X
(5)
M&S/L
(6)
X
(7)
M&S/L
(8)
X
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
2.0
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
3.0
3.1
3.2
3.3
3.4
3.5
3.6
3.7
1.82
1.88
1.95
2.01
2.07
2.13
2.20
2.26
2.33
2.39
2.46
2.53
2.59
2.66
2.72
2.79
2.86
2.93
2.99
3.06
3.13
3.19
3.26
3.33
3.39
3.46
3.53
3.59
3.66
3.72
3.79
3.85
3.92
3.98
4.05
4.11
4.17
4.23
3.8
3.9
4.0
4.1
4.2
4.3
4.4
4.5
4.6
4.7
4.8
4.9
5.0
5.1
5.2
5.3
5.4
5.5
5.6
5.7
5.8
5.9
6.0
6.1
6.2
6.3
6.4
6.5
6.6
6.7
6.8
6.9
7.0
7.1
7.2
7.3
7.4
7.5
4.30
4.36
4.42
4.48
4.54
4.60
4.66
4.71
4.77
4.82
4.88
4.94
5.00
5.05
5.10
5.16
5.21
5.26
5.31
5.36
5.41
5.46
5.51
5.56
5.61
5.65
5.70
5.75
5.79
5.83
5.88
5.92
5.96
6.00
6.05
6.08
6.12
6.16
7.6
7.7
7.8
7.9
8.0
8.1
8.2
8.3
8.4
8.5
8.6
8.7
8.8
8.9
9.0
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
9.9
10.0
10.1
10.2
10.3
10.4
10.5
10.6
10.7
10.8
10.9
11.0
11.1
11.2
11.3
6.20
6.24
6.28
6.31
6.35
6.38
6.42
6.45
6.49
6.52
6.55
6.59
6.62
6.65
6.68
6.71
6.74
6.76
6.79
6.82
6.85
6.87
6.90
6.92
6.95
6.98
7.00
7.02
7.05
7.07
7.09
7.12
7.14
7.16
7.18
7.20
7.22
7.24
11.4
11.5
11.6
11.7
11.8
11.9
12.0
12.1
12.2
12.3
12.4
12.5
12.6
12.7
12.8
12.9
13.0
13.1
13.2
13.3
13.4
13.5
13.6
13.7
13.8
13.9
14.0
14.1
14.2
14.3
14.4
14.5
14.6
14.7
14.8
14.9
15.0
15.1
7.26
7.28
7.30
7.31
7.33
7.35
7.37
7.38
7.40
7.42
7.43
7.45
7.46
7.48
7.49
7.51
7.52
7.53
7.55
7.56
7.57
7.59
7.60
7.61
7.62
7.63
7.65
7.66
7.67
7.68
7.69
7.70
7.71
7.72
7.73
7.74
7.75
7.76
Materials
=
$13,590,000
Labor
=
$4,860,000
Subcontracts
=
$620,000
Overhead
=
$5,040,000
M&S/L
=
$13,590,000 + $620,000
$4,860,000
=
$14,210,000
$4,860,000
(9)
M&S/L
15.2
15.3
15.4
15.5
15.6
15.7
15.8
15.9
16.0
16.1
16.2
16.3
16.4
16.5
16.6
16.7
16.8
16.9
17.0
17.1
17.2
17.3
17.4
17.5
17.6
17.7
17.8
17.9
18.0
18.1
18.2
18.3
18.4
18.5
18.6
18.7
18.8
18.9
19.0
Over 19
=
2.921
(10)
X
7.76
7.77
7.78
7.79
7.80
7.81
7.81
7.82
7.83
7.84
7.84
7.85
7.86
7.86
7.87
7.88
7.88
7.89
7.89
7.90
7.91
7.91
7.92
7.92
7.93
7.93
7.94
7.94
7.95
7.95
7.96
7.96
7.97
7.97
7.98
7.98
7.98
7.99
7.99
8.00
EXHIBIT
58 l
pricing for profit
3
BUDGETED INCOME STATEMENT
SAMPLE
AMOUNT
% OF SALES
Net Sales
$25,000,000
100.00
Cost of Sales:
Materials
Labor (Includes payroll taxes and all union fringes)
Subcontracts
Other Direct Costs
13,590,000
4,860,000
620,000
270,000
54.36
19.44
2.48
1.08
Total Direct Costs
$19,340,000
77.36
Gross Profit
5,660,000
22.64
Overhead
5,040,000
20.16
Net Profit
(Before Income Tax)
$620,000
2.48
Overhead/Total Direct Costs
=
$5,040,000
$19,340,000
=
26.06%
Overhead/Materials and Subcontracts
=
$5,040,000
$13,590,000 + $620,000
=
35.47%
Overhead/Labor
=
$5,040,000
$4,860,000
=
103.70%
Materials and Subcontracts/Labor Ratio
=
$13,590,000 + $620,000
$4,860,000
=
2.92/1
After the materials and subcontracts-to-labor ratio (M&S/L) is calculated,
the overhead factors table in Exhibit 2 is consulted to find the X value of that
M&S/L. For example, an M&S/L of 0.5 yields an X of 2.13, and an M&S/L of
2.0 yields an X of 3.13.
For the hypothetical contractor’s M&S/L of 2.92, the X factor must be
determined by interpolation. The X factor for 2.9 is 3.72; the X factor for 3.0 is
3.80. Since 2.92 is 20% of the difference between 3.0 and 2.9, added to 2.9, the
X factor for 2.92 is 20 percent of the difference between the X factors of 3.72
and 3.80, added to 3.72.
.20 x (3.80 - 3.72) + 3.72 = X
(.20 x .08) + 3.72 = X
.016 + 3.72 = X
3.736 = X
If we round to hundredths, then the X factor for an M&S/L of 2.92 is 3.74.
To determine the dual rates, we need to substitute 3.74 for X and perform
EXHIBIT
4
l 59
CALCULATING DUAL RATES
RATE ON MATERIALS AND SUBCONTRACTS
RATE ON LABOR
Overhead
=
(X) Overhead
=
$5,040,000
(3.74 * $4,860,000) + ($13,590,000 +$620,000)
=
(3.74) * $5,040,000
(3.74 * $4,860,000) + ($13,590,000 +$620,000)
=
$5,040,000
$18,176,400 + $14,210,000
=
$18,849,600
$18,176,400 + $14,210,000
=
$5,040,000
$32,386,400
=
$18,849,600
$32,386,400
=
15.56% of Materials and Subcontracts Cost
=
58.2% of Labor Cost
EXHIBIT
=
5
ESTIMATED COST SUMMARY
DIRECT COSTS (ESTIMATE)
JOB A
JOB B
JOB C
Materials
$180,000
$173,367
$120,000
Labor
60,000
81,633
150,000
Subcontracts
80,000
65,000
50,000
Other Direct Costs
5,000
5,000
5,000
Total Direct Costs
$325,000
$325,000
$325,000
Overhead Applied 15.56% on Materials and Subcontracts
40,456
37,090
26,452
Overhead Applied 58.20% on Labor
34,920
47,510
87,300
Total Estimated Cost
$400,376
$409,600
$438,752
Materials and Subcontracts/Labor Ratio
4.33/1
2.92/1
1.13/1
the calculations illustrated in Exhibit 4. Thus, the dual-overhead rates are
15.56 percent of materials and subcontracts cost and 58.2 percent of labor
cost with the M&S/L of 2.92.
Applying these rates to the job examples in Exhibit 5 produces a
significant improvement over other methods in matching overhead and the
risk of managing labor to each particular project, as shown in Exhibit 6. This
improvement is due to the recognition inherent in the dual-rate method that
EXHIBIT
60 l
pricing for profit
6
VARIATIONS IN OVERHEAD
JOB A
JOB B
JOB C
26.06% of Total Direct Costs
$84,695
$84,695
$84,695
103.70% of Direct Labor Costs
$62,220
$84,653
$155,550
Dual Rates:
15.56% of Materials and Subcontracts plus 58.20% of Labor
$75,376
$84,600
$113,752
the creation of overhead expense is largely driven by management of labor
and less so driven by material and subcontractor procurement. The other
traditional allocation methods ignore this issue.
Overhead applied to Jobs A, B and C varies considerably. However, on Job B,
it remains virtually the same regardless of the method. Overhead allocation
to Job B remains essentially the same, because it has the same materials and
subcontracts/labor ratio as the company had on its budget. Therefore, if every
job had the same materials and subcontracts/labor ratio, any of these allocation
methods would be accurate. Because all contractors have jobs of different
materials and subcontracts/ labor ratios, the dual-rate method is more accurate
than any other method in allocating overhead to these types of projects.
Using the Dual Rates
For any rate chosen, assume that the amount of overhead actually
incurred in the period applies to all of the work performed in that period.
Remember: Every company must calculate its own rates. Do not use any rates
included in this article. Each company’s rates will be different, dependent on
each company’s direct costs and overhead cost structure.
The development of an overhead rate is based on projected future costs.
The best way to determine dual rates is to use a comprehensive 12-month
budget tied into the fiscal year. You should recalculate rates quarterly using
a 12-month rolling budget. Using a 12-month forecast minimizes seasonal
influences on the cost relationships.
Whatever method you employ, a project’s risk is embedded in the additional
costs it generates. Using adequate and accurate overhead recovery rates will
provide a greater level of predictability for costs associated with each project.
Remember that the overhead rates do not consider the desired profits, only
the total cost of jobs (including overhead). Direct costs must be estimated
accurately for the results of overhead application to be acceptable. However,
once you are able to know these costs, you will be in a much stronger strategic
pricing position and know that you are cutting into costs — instead of profits
— in tight pricing situations.
l 61
Eight Steps to Apply the Dual-Overhead Rates
Applying the dual-overhead rates requires discipline and will not usually
change your position in the marketplace. In addition, those idiots who do not
know their costs and who insist on bidding 30% below your best price will still
be in the marketplace. You cannot compete with stupid! Keep in mind that
such price disparities are not always the result of stupidity but sometimes
are borne of brilliance. That competitor may have actually figured out a
substantially less costly way of delivering the project.
1. The first step is to make sure you are using sound estimating practices.
Do your projects consistently overrun estimated direct cost amounts? Do you
have margin erosion on projects? Affirmative answers to these questions may
be indicative of problems with your estimating, project execution or both.
Sound estimating practice is your first discipline to master.
2. The second step is to develop a budget for the coming year. Using
the prior year history and forecast changes in the year ahead will provide a
good start on the budget. FMI recommends updating budgets quarterly or
semiannually to account for changing cost and volume levels in the company.
In effect, you want a rolling budget
that reflects the future based on the
best-known information.
3. Using the methodology
Using adequate and
described in the article, you can
accurate overhead
compute the dual-overhead rates.
Apply these dual-overhead rates to
recovery rates will
a current estimate in your bid
provide a greater
pipeline. This will determine the
overhead that should be allocated to
level of predictability
this project. The overhead allocation
to this project calculates project
for costs associated
breakeven (Direct Cost plus
with each project.
Company Overhead.)
4. The next step is to add a
profit and arrive at a final bid price.
Profit expectations may vary when
considering desirability of the project and client, time of year, availability of
crews, company targeted return on investment and perceived risk. You should
not bid below breakeven, but it does happen for various business reasons. The
reasons are usually bad and lead to the wrong focus for projects and clients.
5. DO NOT submit bids using the dua-rate method until you have
reviewed the accuracy of your calculations on several “dummy bids.” Continue
using your existing pricing strategy while concurrently running a dual-rate
pricing strategy.
62 l
pricing for profit
6. Compare the bidding results to your existing pricing strategy for
several months and note the differences and similarities. Does the dual-rate
overhead method match pricing and bidding objectives more appropriately?
Would you have won more work? Would you have lost projects? You will find
that all three situations occur. The ultimate test is that the dual rates create a
consistent pricing methodology, matching pricing to labor risk management
that is a highly desirable objective. When projects are completed, would the
dual-rate method have more accurately forecast overhead costs? Once you feel
confident in the dual-rate method, begin using it. Always review overhead
allocation from multiple angles prior to submitting your bids to ensure that
there have been no errors in your calculations or assumptions.
7. Constantly challenge costs and productivity to create a more costcompetitive business model. The construction industry is cost-based;
driving costs down is good as long as the cuts do not compromise quality or
customer service.
8. Adjust your dual rates quarterly or whenever significant changes in
volume/overhead occur in your company to keep the overhead allocations
consistent with your current cost structure.
THE DUAL-OVERHEAD RATE IN PRACTICE
F.D. Thomas, Inc. (FDT) has been using the dual-overhead-rate method for a
number of years. FDT is a specialty contractor focused on waterproofing, sealants,
painting, coatings and other specialty contracting services. Dan Thomas, president
of FDT, sent us this note:
The use of the dual-overhead-rate method brings awareness to the relationship
of your (1) backlog, (2) gross profit, (3) overhead and (4) profit. These are my four
knobs of control. I review these key metrics every six months for my three divisions.
We adjust our profit pricing strategy as necessary for the market. It can also lead to
strategic thinking to get the team on track.
The dual rate establishes the overhead, and one can quickly decide if it is a
competitive position. In addition, you can play with the volume and gross profit
knobs to see how to tune them in to the sweet spot for overhead. Then a decision
has to be made whether to invest in estimating, etc., to get the volume and backlog
or to trim overhead. Market conditions, opportunities, bonding capacity, etc., all
have to be taken into account. Making strategic adjustments to the “four knobs”
of the dual-overhead method, in one case, we were able to grow one of our offices’
revenue more than six times what it had been four years ago.
l 63
Conclusion
On average, approximately 10,000 contractors each year file for bankruptcy,
according to Dun & Bradstreet. Large percentages of these contractors do
not know their costs and do not add sufficient profit to their project pricing.
While you have to prepare accurate estimates and be able to perform the
work at the production rates in the estimate, running a profitable construction
business is about more than just bidding and executing work. It is about
studying the economics of your business and having an uncompromising
attitude toward profit. Accurately allocating your overhead costs will bring
clarity to your profit expectations and allow you to make better strategic
decisions in the pursuit of work acquisition opportunities, ultimately resulting
in higher profits for project and company. Q
Tyler Paré is a consultant with FMI Corporation. He can be reached at 813.636.1266 or via
email at [email protected]. Ken Roper is a principal with FMI Corporation. He can be reached
at 303.398.7218 or via email at [email protected].
The ultimate success
of the deal requires
taking the time
and having
the patience
for conducting
a careful and
thorough due
diligence process.
ZURICH FEATURE
KAREN KENIFF
Understanding the Fundamental
Risks of Mergers and Acquisitions
E
very industry sector is experiencing brisk merger and
acquisition activity in 2015 — from pharma and food to
technology and construction. Like companies across all
industries, construction firms are seeking to strategically add value
to their businesses through a merger or an acquisition. The value
in taking this step comes in various forms, including access to new
markets, new customer relationships, geographical expansion, gaining
new capabilities, talent acquisition or simply scaling up to compete
on larger, more complex projects (whether domestically or globally).
For example, as the economy strengthens, some contractors are struggling
to attract and retain a talented labor pool. A merger or acquisition can address
this skilled labor gap. For union firms, a merger or an acquisition can also
provide access to open-shop capabilities.
“Many contractors have the desire to grow but lack the resources to
compete either in new markets or in new high-growth sectors,” says Karen
Keniff, senior vice president of Zurich Financial Services. She notes that
industrial, health care, higher education, energy and power are sectors where
contractors are currently seeking attractive opportunities.
To maximize the value of the deal, Keniff encourages owners and buyers
66 l
understanding the fundamental risks of mergers and acquisitions
to perform aggressive due diligence around previous and current risks.
“Buying a business or merging with another company is a complicated,
high-risk proposition,” Keniff says. “This is likely the largest transaction of a
construction company, and the risks
involved are unlike others typically
faced by the owners or management.”
Failing to adequately
Beware the Speed to Deal
Mergers and acquisitions move
assess a company
quickly, and the risks can be high
and often hidden. Unforeseen
before the purchase
environmental liabilities, managecan have significant
ment liabilities, political risks, and
fiduciary and benefits liabilities can
financial consequences
all endanger an M&A transaction.
and destroy the value
Keniff reminds buyers and
owners that managing the approof the deal.
priate level of due diligence requires
time. “Often,” she says, “it takes a
year or more to manage the details
of the process and negotiations.”
While most owners typically think of financial documents and
accounting systems as the core components of a due diligence process, a more
comprehensive and suitable approach factors in company assets, contracts,
labor relations, and insurance policies and coverage.
A Diligent Look at Key Risk Exposures
According to Keniff, due diligence is critical to limiting risk and liability
exposures. Failing to adequately assess a company before the purchase can have
significant financial consequences and destroy the value of the deal, she notes.
Based on Zurich’s experience with contractors of all sizes during M&A
transactions, here are questions that should be addressed to help assess
potential risks during the frenzied, fast-paced due diligence phase:
Are there any existing exposures?
With the acquisition, the parent company is picking up the new
company’s exposures. Are there issues around environmental practices or
workers’ compensation? What is the culture of the company being bought?
Are employee relations good, or is there a risk of a lawsuit by disgruntled
workers about the merger or acquisition?
What are the contractual obligations being assumed?
In most situations, getting a clean break on contracts isn’t feasible because
l 67
work is still being performed. Companies that don’t closely examine the
backlog of contracts — and that wait until after the deal is done — risk losing
money during the completion process.
It’s particularly important to be aware of union contracts, as the union
may need to agree to the purchase. Keep in mind that contract negotiations
can be costly and complicated, especially if pension plans are involved.
What is the company’s loss history?
To avoid surprises, the buyer should ensure that its private consultant
or in-house team looks as far back in loss history as possible. One area to
examine closely is the statute of repose that will determine the amount of
time in which a party can bring suit.
Is there synergy in risk management practices?
Buyers also need to address disparities in risk management practices and
get everyone on the same page. Having a single, consistent risk management
program based on best practices can ensure that the appropriate risk appetite
is disseminated throughout the organization.
How does the new company manage claims?
From a claims perspective, the parent company should understand the
“legacy claims and claims philosophy” of the company being acquired and the
differences in how the firms manage claims. There should also be a process
in place to absorb ongoing insured claims, which is something the insurance
carrier can help provide.
What are the possible post-deal coverage gaps?
Keniff says that once the sale is made public, the buyers and owners
should involve their insurance carrier or carriers to help determine exposures
and gaps in coverage that need to be addressed, especially Directors & Officers,
Employment Practices Liability and Environmental Liability.
Smoothing the Risks Post-Deal
Determining the appropriate types and levels of coverage for the new
entity is critical, Keniff says, “as the past can come back to haunt the future in
unexpected ways.” Below are three key types of insurance coverage that can
help protect the entity:
Directors & Officers
The completion of the deal doesn’t protect you from the possibility of
future litigation against directors and officers (D&O) of the acquired company.
And if you sit on a board of a company that was acquired, you could be sued
for actions that you took on behalf of the company before it was acquired.
68 l
understanding the fundamental risks of mergers and acquisitions
If your company stopped paying annual premiums to place D&O insurance
after it was acquired, you and the other directors and officers could face
damaging lawsuits.
Employment Practices Liability
There are different employee-related risks in M&A transactions. These
can include obligations from unsettled labor and employment law violations
or ongoing litigation. Former employees can file new complaints post-deal as
well. Some employee benefit-related issues can be challenging to discover,
such as if the seller did not maintain benefit plans as required by compliance
or if it failed to fulfill fiduciary duties.
Environmental Liability
This liability may arise in various forms, including ground contamination,
water pollution or asbestos. There is an increasingly complex body of laws
and regulations that dictate successor liability. It’s important for a buyer to
understand the acquired company’s potential liability for past contamination
on land owned, past noncompliance with environmental laws, and costs that
may be incurred to comply with environmental obligations.
“Every buyer and seller has a different motivation for entering an M&A
situation,” says Keniff. “But the same principle about risk holds true for both;
the ultimate success of the deal requires taking the time and having the
patience for conducting a careful and thorough due diligence process.” Q
Karen Keniff is the senior vice president of Zurich Financial Services. She can be reached at
410.559.8330 or via email at [email protected].
This publication is not intended to be legal, underwriting, financial, investment or any other type of professional advice. Zurich
neither endorses nor rejects the recommendations of the discussion presented. Further, the comments contained in this publication
are for general distribution and cannot apply to any single set of specific circumstances. Any and all information contained herein
is not intended to constitute advice (particularly not legal advice). Accordingly, persons requiring advice should consult independent
advisors when developing programs and policies. Risk engineering services are provided by The Zurich Services Corporation.
© 2015 Zurich American Insurance Company
l 69

FMI Quarterly - Barnes Dennig

Transcription

Similar documents

Energy - Keystone RV

UMA Moosebytes ~ Celtics Tickets, Club Meetings and MORE!

Port Talk

46747 QUAD MAX sell sheet.ai

Go-Kart track open for business

Monte Zwang - Cloudfront.net

TRINI KIDS GOT TALENT Registration Form 2015